By Amanda Cooper

LONDON (Reuters) – The dollar’s biggest rally in 40 years may finally have come to a screeching halt, now that the world’s last central bank – the Bank of Japan – has finally loosened its iron grip on long-term interest rates.

The Bank of Japan shocked markets on Tuesday with a surprise adjustment to control bond yields, allowing long-term interest rates to rise further in a move aimed at mitigating some of the costs of prolonged monetary stimulus.

Bank of Japan Governor Haruhiko Kuroda, who resigned in April, said this was a technical measure intended to improve the way the bond market works and was in no way a form of monetary tightening.

Whatever the case, the timing caught investors by surprise, sending the yen to a six-week high and Japanese government bond yields to seven-year highs – effectively doubling long-term borrowing costs.

The dollar is up 9% this year, as the Federal Reserve raised interest rates to combat inflation at their highest levels in 40 years. It recorded the most gains against the yen, which was affected by the Bank of Japan’s long-term yield control policy.

As other central banks, from the Bank of England, to the European Central Bank, and the Reserve Bank of Australia, raised their own rates, the dollar bulls ran out. Against a basket of major currencies, the US currency is heading for its biggest quarterly loss since late 2010. But the dollar can, so far, count on its advantage against the yen, to prolong its bullish run.

Societe Generale (OTC:) President Kit Juckes says the second-largest increase in the dollar since February 1985 is effectively over.

“Whatever we wear the world through, the Federal Reserve is creeping toward the end of a rate hike cycle,” he said. “The price hikes will get smaller and smaller and eventually there will be nothing and that will be the end of the story.”

Between late 1980 and early 1985, the value essentially doubled. This time, it has gained nearly 30% in less than three years.

The close relationship between Japanese monetary policy and US Treasury bonds adds another twist to the story.

After the Bank of Japan’s decision, the 10-year US Treasury note rose as much as 13 basis points, to over 3.71%. It was last up 9 basis points on the day at 3.673%.

With Japan being the largest holder of US Treasury bonds in the world, US government debt fortunes are more intertwined with the yen than anyone could wish for in the Federal Reserve.

said Adam Cole, currency analyst at RBC Capital Markets, referring to domestic investors who hold the bulk of Japanese government debt.

He said it all boils down to whether or not Japanese investors hedge their exposure to the Treasury.

Hedging bets

Yields on the protected 10-year Treasury note are now yielding less than -1%, according to Cole data, after falling below the 10-year Treasury yield earlier this year.

“Many Japanese yen-based investors, who have enjoyed years of positive hedges in Treasuries, now face a stark choice over what has become an extremely negative-yielding asset class,” Cole said.

As short-term US Treasury yields have risen – reflecting the belief among investors that the Federal Reserve will continue to raise interest rates for the coming months – they have outpaced longer-term yields, making hedges much more expensive.

This pushes foreign exchange rates below current or spot rates, meaning that investors who locked in their exposure to the greenback — which they need to buy Treasuries — face the possibility of a loss when they eventually exchange those dollars for yen.

Any advantage an investor gains by holding higher-yielding treasury bonds over Japanese government bonds is eliminated at the cost of the hedge.

“For a Japanese investor, the question is – if I have to hedge, is there any point in holding (US bonds) should I just sell my Treasuries?” said Juckes of Societe Generale.

On the sidelines, it appears that selling Treasuries to take advantage of better domestic yields would be a good option. But analysts said the pressure was “on the sidelines”, not least because of the sheer size of Japanese investors’ holdings of US debt.

“In terms of Japanese investors bringing money home – even if you look at a dollar/yen basis for example, you can still get a massive bounce in US Treasuries if you’re a Japanese investor, before switching back to the yen,” the strategist said. Richard Maguire.

“So I don’t think the math adds up,” he said. “I don’t think this sees wholesale Japanese reinvestment into Japanese government bonds, which would be negative for (German) bunds, (Italian) bunds, and US Treasuries.” .

JPMorgan (NYSE) strategists say high-quality corporate bonds will also feel the pinch, as they fuel global volatility, but there is an upside.

“The question now will be whether the market thinks this is just a technical adjustment or not

Eric Beinstein and Nathaniel Rosenbaum said it was the beginning of a more militant axis.

(This story has been reworded to fix a typo in the title)